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Deep Profits in Deep-Water Drilling

One sector of the oil patch is still sizzling.

Deep-water drilling company Diamond Offshore(NYSE:DO) announced fourth-quarter and full-year earnings yesterday morning. Results were solid, with revenues and earnings showing big increases on both a quarterly and an annual basis. Compared to the fourth quarter of 2005, revenues rose 57% and earnings per share rose 106%. Full-year figures demonstrated similarly gaudy growth, as revenues rose 68% and earnings per share were up an astronomical 168%. Furthermore, there are substantial reasons to believe this business is going to remain solid for several years to come.

Higher prices, higher profitsThe driver behind these results has been an incredible increase in dayrates (the industry term for pricing) across the entire industry. Diamond Offshore and its competitors, including Transocean(NYSE:RIG), Global Santa Fe(NYSE:GSF), and Noble Corp.(NYSE:NE), have been able to increase prices across all classes of drilling rigs. (For Fools interested in a comparison of these companies, there was recently a great post from deadcat2 on the Diamond Offshore discussion board.)

Diamond Offshore divides its fleet into three categories: high-specification rigs, which are capable of drilling in water depths of more than 3,000 feet; intermediate rigs, which operate at between 1,000 and 3,000 feet of water depth; and jack-up rigs, which stand on the ocean floor in up to 350 feet of water depth. Dayrates for all classes have shown big increases over the past year.

Diamond Offshore Dayrates by Rig Class

Rig type

High-specification

Intermediate

Jack-up

End of 2006

$253,000

$155,000

$113,000

End of 2005

$181,000

$81,000

$69,000

Change

40%

91%

64%

Beyond the year-over-year increases, rates for high-specification and intermediate rigs also increased over the third quarter of 2006, suggesting that prices are still on the upswing. Utilization has been running near 90% for all classes of rigs during the past year, with downtime varying from quarter to quarter based on maintenance schedules.

The one weak point in results is the jack-up rigs. Rates for jack-up rigs have gone flat since last summer. There is a reasonable supply of cold-stacked (idle) jack-up rigs in the Gulf of Mexico, keeping a lid on prices. Operators have been moving rigs to other parts of the world, but there are a number of new-built rigs scheduled to enter service in coming years. This suggests that shallow-water operators like TODCO(NYSE:THE) might have a rough time increasing rates going forward.

Shining futureThe rising dayrates also bode well for the future, as high-specification rigs are generally signed on to long-term contracts. Therefore, much of Diamond Offshore's fleet is still operating under old contracts at lower rates. As these contracts expire, they will be renewed at higher rates, leading toward reasonably predictable earnings increases for the next two years. On top of results posted in 2006, analysts are projecting a 73% EPS increase in 2007, followed by 45% EPS growth in 2008.

It appears that solid results could also continue well beyond 2008. Along with the earnings results, the company also announced a four-year contract for its high-specification rig, Ocean Confidence, at a dayrate of $500,000 beginning in January 2008. Furthermore, the company is in the process of upgrading a number of its deep-water rigs for service in up to 10,000 feet of water depth. Once complete, these retrofitted rigs will go into service at dayrates far above current levels.

Sharing the wealthIn addition to delivering solid results, Diamond Offshore shares the good fortune with shareholders in the form of dividends. In addition to a $0.50-per-share annual dividend, Diamond recently announced a $4-per-share special dividend. Last year, the company paid a $1.50-per-share special dividend in addition to the regular dividend. To top it all off, the number of shares outstanding has barely budged over the past year.

Foolish final thoughtsFor investors seeking a sweet spot in the oil patch, it is hard to beat the deep-water drilling companies. For the next couple of years, Diamond will benefit from rising rates and nearly full utilization. The company has retrofitted rigs coming into service at higher rates, and existing contracts are being renewed at higher rates. Supply in the industry is constricted by the $700 million price tag and three- to four-year lead times for a new rig, combined with conservative operators who have been burned in the past from adding capacity too quickly. If you are interested in investing in this sector, shares are quite volatile, meaning there should be multiple opportunities to pick up shares at a discount. The next time Diamond swoons, you might just see me in the trading pits adding to my position.

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Fool contributor Robert Aronen never met a deep-water driller he didn't like. He owns shares of Diamond Offshore, Transocean, and TODCO, but no other company mentioned in this article. He also has them in his CAPS portfolio, where he is ranked 1,573 out of more than 22,000 players. The Fool's disclosure policy is at home on land and underwater.